UC Berkeley

During recessions, either declines in actual capital or increases in required capital may intensify pressures on banks. One way for banks to boost their capital ratios is by reducing their lending. However, one effect of systematic reductions in the supply of bank loans during recessions would likely be to accentuate the magnitudes of macroeconomic fluctuations. To reduce this source of “procyclicality”, it has been proposed that Basel II include “escape clauses”. Such clauses might, for example, operate so as to raise required bank capital during macroeconomic expansions and reduce it during downturns. Apart from formal escape clauses, procyclicality might be reduced or even reversed in practice if banks exercise sufficient discretion in reporting their charge-offs and loan loss provisions. We propose two hypotheses about the past cyclicality of such discretion. We hypothesize that individual banks tended to report fewer charge-offs and provisions when the banking system was troubled than when it was generally healthier. That suggested our second hypothesis: Banks tended to cluster more when the banking industry was troubled. Banks would maximize the value of their reporting discretion by clustering more then; being similar to other banks raised the likelihood that a bank would be able to exert reporting discretion when it encountered difficulties, because other, similar banks, and thus the banking system as a whole, would likely be troubled at the same time. We found some support for our hypotheses at large U.S. banks. During the late 1980s, when banking was troubled and bank capital ratios were low, individual banks reported fewer charge-offs, ceteris paribus, when the capital ratios of their peers were lower. During the late 1990s, in contrast, when capital ratios were higher, charge-offs at individual banks were not systematically related to the capital ratios of peer banks. We also found that the equity and the asset betas of individual banks tended to cluster more when banking was more troubled than they did when banking was less troubled.